When a company buys back its own shares with corporate cash, this is a share repurchase. Repurchased shares become treasury shares or are canceled, and either way it reduces the number of trading shares. They can be seen as an alternative to cash dividends, which are direct distributions of corporate cash.
Share repurchases have some characteristics which might may them more appealing for management and shareholders. Repurchases are flexible and do not have to be regular. They avoid tax penalties from cash distributions. And they can reduce potential share dilution events, like a surge in employee option conversions. Managers can also announce a share repurchase as a signal to the market that the stock is undervalued.
- Open Market – The most commonly used method, under this flexible method, open market share repurchases can occur at any time at market prices.
- Fixed Tender Offer – Used to quickly complete a repurchase, the company will offer a fixed price to shareholders with a set quantity of shares to be bought. If there is an excess of supply, the repurchases will be done on a pro-rata base.
- Dutch Auction – Instead of announcing a fixed price, the company will announce a range of prices that it is willing to pay for a set number of shares. Offers will be in the form of bids, and the lowest bids that fulfill the tender offer will be the shares repurchased. This method uncovers the minimum price at which the repurchase can occur at.
- Direct Negotiation – Given major shareholders, a company may directly negotiate with that shareholder to buy back shares.
Effects of Share Repurchases on EPS
A share repurchase financed with retained cash can lead to a decrease in shareholder’s equity and assets. This increases the leverage of the company.
If it is done with retained cash and net income is relatively stable over the repurchase period, earnings per share should increase, as net income is divided by fewer shares.
If the repurchase is done by financing the cash needed, the effect on EPS is dependent on the cost of financing. A high cost of financing can lead to no change, or even a decrease in the EPS.
- EPS after buy back = (Earnings – After tax cost of funds)/Remaining shares
- After tax cost of funds = Financing amount x Cost of financing
Effects of Share Repurchases on Book Value
When the market price is greater than book value per share, a share repurchase will decrease book value per share further. If market prices are less the BVPS, BVPS will increase after a repurchase.
- BVPS after buy back = (Book value – Cash spent on repurchase)/Remaining shares
Equivalence of Cash Dividends and Share Repurchases
All else equal, a share repurchase should have the same effect on shareholder’s wealth than a cash dividend using the same amount.